Phoenix saw the addition of another -1.7 million SF of net vacant office space to the market in 2023, as tepid demand and broad-based economic uncertainty continued to pressure the sector. Total empty space has climbed 50% since the end of 2019, driving the metro-wide vacancy rate from 11.0% in 19Q4 to 16.1% today, matching a level last seen in 2015.
The lack of meaningful construction activity has helped avoid exacerbating the supply and demand imbalance. Developers completed just 740,000 SF over the past 12 months, and only 1.1 million SF is currently underway. The bulk of the pipeline is medical properties, which have held up better than their traditional office counterparts.
Despite an unrelenting rise in metro-wide vacancy, rents in the Phoenix office market have been surprisingly stable. Average asking rents climbed 3.2% over the past 12 months, outpacing the national average of 0.7%. When accounting for inflation, however, annual rent growth is modestly negative. In addition to the sector’s macro headwinds, the upswing in sublease availability could play a role in softening rents over the near term. The average base rent for sublet space is about 20% lower than direct space, providing tenants with affordable alternatives. CoStar’s Base Case forecast calls for nominal rent growth to turn negative by 24Q3.
Sales volume remains modest as elevated debt costs, scarce availability of financing, and the sector’s uncertain outlook drive a prolonged period of price discovery.
Moving forward, expectations are for further weakness in the Phoenix office market over the near to midterm. The expiration of in-place leases will force office users to make decisions about their space needs, many of whom are expected to downsize their footprints, given lower office utilization rates and space-per-worker requirements. A potential economic slowdown presents further headwinds and could give tenants pause before making large, long-term space commitments.
Space availability is highest at 4 & 5 Star properties, with 27.5% of this inventory currently available for lease. A combination of high-profile office closures by companies like Carvana and Silicon Valley Bank and the delivery of vacant buildings has contributed to the weakness. Furthermore, the bulk of sublease accumulation has also been at the top of the market, particularly for Tempe and Chandler properties that were previously leased to expanding technology and insurance firms. Filling these larger blocks of space has proven to be difficult as many users gravitate toward smaller footprints at multi-tenant buildings in the most desirable areas. As a result, the Phoenix office market has about 7.7 million SF available for sublease, nearly tripling the pre-COVID 15-year average of about 2 million SF. The share of total inventory on the sublease market is now at 3.9%, ranking Phoenix as one of the most heavily impacted sublease markets in the country.
Demand has been more resilient at smaller properties. Although the overall market has seen a steady rise in vacancy over the past three years, the average vacancy rate for buildings with less than 50,000 SF has compressed since the onset of the pandemic, falling from the high-8% range in 19Q4 to the low-7% range in 23Q4. One factor driving the improvement is likely the strength of leasing demand for smaller blocks of space. Indications from market participants are that a bifurcation has emerged in terms of lease size, with spaces under 5,000 SF being in particularly high demand. Some owners are considering subdividing larger floor plates into smaller suites, though the capital outlays to add walls and hallways are costly.
The pace of rent growth has been decelerating since early 2022, as rising vacancies and weaker tenant demand reduce landlords’ ability to raise rates. Even so, Phoenix rents have held up better than most other markets. Over the past 12 months, the metro recorded a 3.2% increase in average asking rents, ranking the Valley as one of the best-performing markets in the country. For comparison, rent growth for the U.S. as a whole is up just 0.7%. Although underlying office demand has undoubtedly shifted, many property owners have opted for increased concessions or higher TI allowances to compete for tenants, rather than slashing asking rents.
Affordability of office space remains a key factor for attracting businesses to the market. At $29.00/SF, the average office rent in Phoenix is more than 15% less than the National Index of $35.00/SF, and the discount relative to West Coast markets is even larger, with average rents in San Francisco and San Jose more than double that in Phoenix.
The expectation is for rent growth to turn negative in the coming year as elevated sublease availability intensifies competition in the broader market. Additionally, there could be some downward pressure on rents from new owners who acquired properties at a steep discount and can thus afford to lower rents to attract users. CoStar’s current forecast calls for average asking rents to reach the -2% range by year-end 2024.
Supply-side pressure remains modest in the Phoenix office market as 2024 kicks off. Just 740,000 SF of net new office space was completed over the past 12 months, representing a meaningful slowdown from the nearly 2.5 million SF that was added per year from 2015 to 2017. Weaker underlying tenant demand, coupled with higher development costs and limited availability of construction financing, has made it difficult for builders to profitably break ground. As a result, construction starts have slowed to the lowest level in over a decade with the bulk of the current pipeline composed of smaller properties and medical office space, two segments of the market that have shown more resiliency. About 1.1 million SF is currently underway, representing just 0.6% of total inventory.
Geographically, Tempe has been one of the primary recipients of new space. The area was a popular expansion option for technology, finance, and insurance companies in the half decade leading up to the pandemic, and developers poured millions of SF of high-end office space into the submarket to meet demand. Two speculative office projects delivered their first phase in 2023, adding 260,000 SF of vacant office space to the submarket. Tempe Vale, a two-building development that was originally planned for Carvana, is underway on its second phase, which will add 133,400 SF upon delivery in 24Q2.
The pace of transaction activity has slowed considerably in the Phoenix office market as elevated vacancies, rising interest rates, and uncertainty surrounding the sector’s long-term outlook keep sales volume restrained. About $1.3 billion traded in the most recent 12-month period, a steep decline from the most recent three-year average of $2.5 billion per year.
Private investors have taken a larger share of the buyer pool, accounting for 75% of deal volume over the past year. This compares to a five-year average of just over 50%. These investors typically target properties at lower price points and as a result, the share of sales volume for assets priced less than $5 million has increased from about 25% in 2021 and 2022 to 40% in 2023.
Looking forward, upcoming loan maturities could pose a potential risk. CoStar is tracking more than $800 million worth of CMBS debt coming due through 2025, which may cause challenges for investors when the time comes to refinance at current interest rates. With valuations showing signs of decline, some owners may need to bring additional capital to the table to meet current lending standards, which often include lower loan-to-values. Nationally, CMBS delinquency is on the rise and could move higher in the coming quarters as underlying property performance faces headwinds.
The number of companies moving to metro Phoenix is noteworthy, but the diversity of industries has helped sustain the region’s long-term stability. Phoenix was synonymous with cheap labor and land that attracted call centers and back-office operators more than a decade ago. The economy depended on industries associated with household growth—construction, lending, brokerage, tile and cabinet manufacturers, etc. Because of its past reliance on housing, Phoenix was among the hardest-hit metros during the Great Recession; the market lost more than 240,000 jobs, 25% of which were in the construction industry alone. Phoenix recovered from the Great Recession about two years after the U.S. The companies that Phoenix is attracting have evolved, and the market has emerged as a hub for advanced manufacturing, aerospace, logistics, technology, life sciences, and finance.
The competitive advantage and growth drivers that have historically stimulated growth in the Valley remain strong. Relative affordability and job prospects are attracting people living in dense and expensive cities to Phoenix. The increase in remote work has given more people mobility and has enticed residents in California or East Coast markets to relocate, bringing their high-wage jobs with them. Population growth, a diversifying economy, relative affordability, and business-friendly regulation strengthened the Phoenix value proposition. These characteristics attracted an average of 175 net new people to the Phoenix metro each day in 2022 and made Maricopa County the fastest-growing county in the country, on an absolute basis.